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The collapse of a number of CeFi platforms provides a stark warning to investors. While these platforms mimicked traditional banks, albeit on the blockchain, the lack of oversight or regulation meant their business model was unsustainable.
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About the author: Franz Bergmueller is CEO of SEBA Bank, a bank with digital assets.
Digital assets are at an inflection point. Institutional engagement with the asset class is reaching unprecedented levels. That development may seem strange in light of the significant decline we’ve seen in the crypto markets, but this bear market is unlike anything we’ve seen before.
Institutional players are now taking a long-term view when it comes to digital assets, despite short-term volatility. This summer, leading asset managers including Abrdn, Blackrock and Charles Schwab have invested in digital asset offerings. This development is representative of a wider trend, with a wide range of investors demanding access to the sector. According to a PwC report earlier this year, more than a third of traditional hedge funds are now investing in digital assets, almost double from the previous year.
This year, a number of centralized financial companies have also collapsed. Known as CeFi, these are relatively traditional financial firms that specialize in digital assets. Many are easily regulated, if at all. High-profile failures have also fundamentally reshaped the go-to-market strategy for many investors. Lending platforms Celsius, Voyager and Vauld have all declared bankruptcy with little clarity for customers about what will happen to their assets. Investors who wish to participate in the space are now seeking transparency, security and deposit protection.
The demand is here, led by a new understanding that this is a volatile asset class. However, the industry needs to address a number of key concerns to enable institutional investors to operate with confidence in the sector and unlock the next phase of growth.
We can start with learn from CeFi wipeout. The collapse of a number of CeFi platforms provides a stark warning to investors. While these platforms mimicked traditional banks, albeit on the blockchain, the lack of oversight or regulation governing their practices meant their business model was never going to be sustainable. As soon as there was significant market turbulence, the model unraveled and it became clear that some platforms did not have sufficient deposits to support customer withdrawals.
Their failure provides a warning that there needs to be a clear set of ground rules in place for institutional investors to engage with digital assets at scale. The world’s largest asset managers will simply not engage in markets where basic financial requirements are not met or monitored effectively. To encourage such companies to engage with digital assets, regulators need to put in place liquidity and capital requirements. They must introduce standardized deposit protection for investors and monitor them effectively.
Many investors have still not received funds they had deposited on bankrupt CeFi platforms. The new legal and regulatory frameworks for digital assets in many jurisdictions mean that it is not clear when they will receive funds, or even how much they will be entitled to. Regulation must deal with these issues.
A number of jurisdictions have led the way on digital asset regulation: Switzerland and Singapore have two of the most well-established frameworks, providing clear rules for operators to engage with confidence in the sector. These jurisdictions are now joined by other states keen to unlock the burgeoning growth and innovation being cultivated in the sector.
In June, the EU agreed on a landmark bill on digital assets. “Markets in Crypto Assets” harmonises rules for digital assets and infrastructure across the 27 member states and empowers the European Securities and Markets Authority to ban or restrict crypto platforms that fail to adequately protect investors. This will contribute to large institutional players being able to invest in the digital asset sector with confidence.
Other leading financial centers are following the EU’s plans. In particular, President Biden’s executive order on crypto has forced US regulatory agencies to work together to develop a comprehensive, overarching framework for the asset class. Similarly, the UK has stated its intention to become a global hub for digital assets, with the Treasury announcing it would develop a regulatory framework and introduce a “financial market infrastructure sandbox” to enable companies to innovate in the sector.
States would be better off cooperating when developing regulation. Doing so would avoid recreating existing frictions in our financial infrastructure. This regulation should assess the fallout from the CeFi meltdown and require greater transparency, as well as strict capital and liquidity requirements for the operators.
The final piece of the institutional puzzle lies in security. Over $2.4 billion in funds have been hacked or exploited in the crypto industry since January. Investors need institutional infrastructure to reduce the risk of their assets being compromised.
Considerable debate has focused on the merits of particular key management technologies for institutions. Investors should look beyond technology when considering counterparties. Regular independent reporting on custody solutions should be considered an essential security requirement, while deposit insurance can also guarantee reimbursement in the event of a compromise.
As shown by the CeFi collapse, regulators must also require companies to segregate assets on their balance sheets. The assets of investors using counterparties without segregation are at risk in the event of financial collapse.
It is clear that institutional engagement with digital assets is entering a new phase of growth. The first moves to develop clear regulation and the availability of mature institutional infrastructure combine to encourage investors to participate with greater confidence in the sector. Digital assets and associated infrastructure will play a key role in the financial services of the future. With a blueprint for institutional adoption now in place, it’s up to investors to make sure they don’t risk being left behind.
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